European leaders are testing the latest version of their debtcrisis strategy in Spain, granting Prime Minister Mariano Rajoymore time to reduce the budget deficit in exchange for deeperspending cuts.

Rajoy yesterday announced 65 billion euros ($80 billion) ofausterity measures in a renewed effort to meet European Unionbudget targets after he was granted a one-year extension on thedeadline to meet EU limits.

“Europeans are learning from past mistakes,” said ChristianSchultz, a senior economist at Berenberg Bank in London and aformer European Central Bank official. “The stick is necessary butthe carrot is also good.”

Europe's concession to recession-wracked Spain has raisedexpectations in Ireland and Portugal that they can win more time torein in their budget deficits after Germany's hardball tactics inGreece spurred a rebellion against bailout politics there.

Spanish bonds rose for a third day today. The extra yieldinvestors demand to hold Spanish 10-year debt instead of thebenchmark German bunds dropped 4 basis points to 527 basis pointsat 11:15 a.m. in Madrid.

“People can see that they are serious,” said Javier Morillas,professor of international economics at San Pablo CEU University inMadrid. “I don't think these are the last measures we'll see, andthey certainly aren't the last cartridges Rajoy has left.”

Rajoy's budget package came as Spain finalizes the conditions ofa 100 billion-euro bank rescue bank that will allow InternationalMonetary Fund officials to intervene in the process ofrestructuring the banking system and tightens scrutiny overspending plans.

European leaders also held out the prospect of buying Spanishdebt to trim yields as long as Rajoy complies with theirconditions, which include transferring powers from the EconomyMinistry to the Bank of Spain and bolstering the central bank'sindependence.

Rajoy is also seeking additional cuts from the 17 regionalgovernments, which control health and education. Even as Spain'sown access to capital markets is narrowing, the central governmentis planning to help states fund themselves on markets. BudgetMinister Cristobal Montoro meets regional finance chiefs today at 4p.m. in Madrid to discuss the plan.

Pay cuts and holiday restrictions for public workers will save6.3 billion euros a year, Deputy Budget Minister Antonio Betetasaid yesterday.

Greek Recession

With the extra year, Spain has until 2014 to bring its deficitwithin the EU's 3 percent limit. European finance ministers agreedto loosen the 2012 deficit goal to 6.3 percent of GDP from 5.3percent. Still, ministers urged Spain to step up budget cuts.

Even after the concessions on the timing, Europe's demands mayend up pushing Spain deeper into recession like Greece, which hasbeen in recession since 2008. The Spanish program brings the fiscaltightening for this year to about 65 billion euros, Schultzestimates, after three previous packages.

“Just when you think reason and pragmatism are returning,European policymakers resort to type,” said Dario Perkins, aneconomist at Lombard Street Research Ltd. in London, in researchnote. “Significant fiscal tightening was the last thing the economyneeded.”

Rajoy is already facing a backlash from Spanish voters withunemployment at 25 percent and the economy sliding deeper into itssecond recession since 2009. Miners who've been striking for thepast seven weeks clashed with police outside the industry ministryin Madrid yesterday as they demanded the government reinstatesubsidies they say are needed to keep their industry alive.

Spain's two largest unions, Comisiones Obreras and Union Generalde Trabajadores, called a day of demonstrations for July 19 toprotest, saying the cuts target the poor and the middle classwithout affecting companies or the wealthy.

The premier also scrapped a mortgage rebate, reversing a policyhe implemented in December at his second Cabinet meeting to enactan election promise. At the same time, he had raised pensions tomeet another pledge. Yesterday, he said he'd present parliament'spension committee with a bill to make retirement benefits moresustainable.

Even with the new targets, Spain needs to cut the deficit by 2.6percent of GDP as the economy shrinks. The deficit overshot lastyear as the economic downturn bit into tax revenue and regionsunearthed undeclared bills. The government forecasts a contractionof 1.7 percent this year and Rajoy said today the slump wouldcontinue next year.

“We have very little room to choose,” Rajoy told the nationalparliament in Madrid. “I pledged to cut taxes and now I'm raisingthem. But the circumstances have changed and I have to adapt tothem.”

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